Appendix B
THE MECHANICS OF AN ACCOUNTING SYSTEM
Learning Objectives
1. What is the general ledger system and how does it work?
2. What are the steps in the accounting cycle?
3. What adjustments are needed before preparing financial statements and
how do you make those adjustments?
4. What is closing and why is it necessary
1
THE GENERAL LEDGER ACCOUNTING SYSTEM
The general ledger system, also known as bookkeeping, is the traditional
method of keeping track of a company’s financial transactions.
Journals—the first place you record all transactions that affect the
accounting equation (i.e., assets = liabilities + owner’s equity.) On a daily
basis, accounting clerks record in journals.
General ledger—the place where the running balance of each account (e.g.,
cash, A/R, A/P, sales revenue) is kept. Periodically (e.g., at the end of the
day, week or month), accountants post entries recorded in the journals to
the general ledger.
At the end of the year, the account balances of the general ledger are used
to create financial statements. The procedure that takes us from the daily
journals to the year-end financial statements is called the accounting cycle.
2
DEBITS AND CREDITS
To show increases and decreases to accounts, we used + & -. Now we will
use debits and credits, which mean left and right.
Account Title (e.g. Cash)
(debit side) (credit side)
How to show account balances with debits and credits
1. Assets-- with debits, with credits. Normally assets have a debit
balance.
Cash
5/1
$ 500
5/2
5000
5/5
(3000)
2500
(D)
Cash
(C)
5/1 $500 5/5 $3000
5/2 5000
2500
2. Liabilities-- with credits, with debits. Normally has credit balances.
A/P
5/1
5/2
5/5
(D)
$ 500
5000
(3000)
2500
A/P
(C)
5/5 $30005/1 $500
5/2 5000
2500
3
3. Equity-- with credits, with debits.
Revenues & Contributed Capital increase Equity
Expenses, & Dividends decrease Equity
Contributed Capital (e.g., stock) increases equity, Contributed Capital with
credits.
Stock
5/1
$ 500
5/2
5000
5500
(D)
Stock
(C)
5/1 $500
5/2 5000
5500
Revenue--increases equity, so revenue with credits.
Revenue
5/1
$ 500
5/2
5000
5500
(D)
Revenue
(C)
5/1 $500
5/2 5000
5500
Expenses—decreases equity, so expenses with debits that decreases
equity.
Expense
5/1
$ 500
5/2
5000
5500
(D)
Expense
5/1 $500
5/2 5000
5500
(C)
Dividends—decreases equity, so expenses with debits, that decreases
equity.
Dividends
5/1
$ 500
5/2
5000
5500
(D)
5/1
5/2
4
Dividends (C)
$500
5000
5500
How to record transactions using debits and credits
Suppose a company purchases $100 of inventory on account.
1. Record the transaction in terms of the accounting equation:
Assets
Inventory $100
=
=
Liabilities
A/P $100
Owner’s Equity
2. Recording the transaction in a Journal using debits and credits:
Account
Inventory
A/P
Dr. (+A -L -E)
$100
Cr. (-A +L +E)
$100
After recording the transaction, post the entry to the General Ledger
accounts as follows:
(D)
A/P
(C)
Bal $ 0
$ 100
00
(D)
Inventory
Bal.
0
$100
$100
5
(C)
THE ACCOUNTING CYCLE
The Accounting Cycle
During the Year
1. Record transactions in the journals
2. Post to the general ledger
At Year End
3. Prepare a Trial Balance.
4. Prepare financial statements.
5. Record closing entries and post them to the general ledger
6. Prepare post-closing trial balance.
A trial balance is a list of all the accounts, each with its debit balance or its
credit balance.
6
Example
TRANSACTIONS FOR JANUARY 2020
January 01 Team Shirts Inc. sells $5,000 in stock to Bill.
January 01 Team Shirts borrows $500 from Bill’s Mom.
January 05 Team Shirts buys wholesale 100 T-shirts for $400 cash.
January 10 Team Shirts pays a company $50 cash for advertising.
January 20 Team Shirts sells 90 T-shirts for $10 each in cash.
January 30 Team Shirts repays Bill’s Mom $500 plus $5 in interest.
January 31 Team Shirts pays a $100 dividend.
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1. Record transactions in the journal
Journal
Date
Asset Accounts
January 01
Liability
Accounts
1-Jan
$5,000 Con.
Cap.
$500 Notes
Pay
Cash
Con. Cap.
$5000
Cash
N/P
$500
Inventory
Cash
$400
Inventory
January 10
Team Shirts pays a company $50 cash for advertising.
( $50) Advert
Adv Exp
10-Jan ( $50) Cash
Exp
Cash
20-Jan
$900 Revenue
($360)
Inventory
($360) CGS
(500) Notes
Pay
$400
$400
$50
$50
Cash
Revenue
CGS
Inventory
$900
$900
$360
$360
( $5) Int. Exp
N/P
Int. Exp
Cash
$500
$5
Dividend
Cash
$100
$505
Team Shirts pays a $100 dividend.
($100)
Dividends
31-Jan ( $100) Cash
End
Bal
$500
Team Shirts repays Bill’s Mom $500 plus $5 in interest.
30-Jan ( $505) Cash
January 31
$5000
Team Shirts sells 90 T-shirts for $10 each in cash. Cost was $4/unit
$900 Cash
January 30
Cr (-A +L +E)
Team Shirts buys wholesale 100 T-shirts for $400 cash.
5-Jan ( $400) Cash
January 20
Dr (+A – L -E)
Team Shirts borrows $500 from Bill’s Mom.
$500 Cash
January 05
Account
Team Shirts Inc. sells $5,000 in stock to Bill.
1-Jan $5,000 Cash
January 01
Equity
Accounts
$5,385
= $0
+
$5,385
8
$100
2. Post to the general ledger (red numbers are closing entries)
General Ledger
D
Cash
0 100
5000 400
500 50
900 505
5345
C
D
Notes Payable
0
500 500
0
C
D
Revenue
C
0
900
900
D
Inventory
900
C
385
0
0
400 360
40
D
Dividends
D
Adv. Exp.
0
50
50 50
C
C
0
0
100
100
D
100
D Contributed Cap.
CGS
C
0
360
360
0
360
C
0
0
5000
5000
D
D Ret. Earnings
0
900
50
360
5
100
Int. Exp
0
5
5
5
0
Students do 26B, 33B
9
C
C
3. Prepare Unadjusted Trial Balance.
Trial Balance
Account
Cash
Inventory
Debit
5345
Credit
40
Notes Payable
Revenue
900
Cost of Goods Sold
360
Advertising Expense
50
Interest Expense
5
Dividends
100
Con. Cap
_______
5000
5900
5900
Total
10
4. Prepare financial statements.
Team Shirts Inc.
Income Statement, For the Month of January, 2020
Sales Revenue
- Cost of goods sold (ie, inventory exp.)
- Advertising Expense
- Interest Expense
= Net Income
$900
- 360
- 50
- 5
$485
Team Shirts Inc.
Statement of Changes in Equity, ended January 31, 2020
Beginning Capital
+/- Capital
Ending Capital
$
0
5,000
5,000
Beginning Retained Earnings
+/- Net Income
- Dividends
= Ending Retained Earnings
$
0
485
- 100
385
Ending Equity $5,385
Team Shirts Inc.
Balance Sheet, ended January 31, 2020
Assets
Cash
+ Inventory
= Total Assets
$5,345
40
$5,385
Liabilities & Equity
+ Retained Earnings
+ Capital Stock
= Total
$385
$5,000
$5,385
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5. Close the temporary accounts.
Permanent accounts are accounts that are never closed. They are the asset,
liability, and equity accounts.
Temporary accounts are the revenue, expense, and dividends accounts.
Their balances are brought to zero at the end of the accounting period,
called closing the accounts.
Revenue, expense, and dividends accounts are temporary accounts. We
need to close these accounts at the end of the period in order to start the
next period with zero balances. We close these accounts to retained
earnings (RE). By doing this, we transfer the balances from the revenue and
expense accounts to retained earnings.
Closing Entries:
Dr Revenue
Cr Retained earnings
xxx
xxx
Dr Retained earnings
Cr Expenses
xxx
Dr Retained earnings
Cr Dividends
xxx
Date
Jan 31
Jan 31
Jan 31
Jan 31
Jan 31
xxx
xxx
Account
Dr (+A – L
-E)
900
Revenue
Retained earnings
Retained earnings
CGS
Retained earnings
Int Exp
Retained earnings
Adv Exp
Retained earnings
Dividends
Cr (-A +L +E)
900
360
360
5
5
50
50
100
100
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6. Prepare post-closing trial balance.
Post-Closing Trial Balance
Account
Cash
Debit
5345
Inventory
Credit
40
Notes Payable
Capital Stock
Retained Earnings
Total
5000
_______
385_
5385
5385
P32B, EB-22A
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Summary
Our goal is to understand the accounting system that produces financial statements, such as
THESE. P. 51
The process to enter transactions in terms of the accounting equation.
Accounting equation
A (owned) = L (owed) + E (Net Worth)
Process of elimination
If A , either: (1) A ; (2) L ; or (3) E
If A , either: (1) A ; (2) L ; or (3) E
If L , either: (1) A ; (2) L ; or (3) E
If L , either: (1) A ; (2) L ; or (3) E
Revenues & Capital Stock increase Equity
Expenses, & Dividends decrease Equity
Transaction: Pay $100 for dividends.
1. Record the entry in terms of the accounting equation.
Assets
Cash (100)
Liabilities
Equity
Dividends (100)
2. Record the entry in terms of debits and credits.
Account
Dr. (+A -L -E)
Cr. (-A +L +E)
Dividends
100
Cash
100
3. Post the entry. Suppose Cash has a beginning balance of $200 and Stock had a beginning
balance of $200.
(D) Cash (C)
$200
$100
$100
(D) Dividends (C)
0
$100
$100
(D) Stock
(C)
$200
$200
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Example
March 01
Purchased computer for $4,000 with $1,000 down and a 3month12% note for $3,000. The computer is expected to last
for 3 years and have a residual value of $400.
March 10
Paid the rest of last month’s advertising bill, $50.
March 15
Collected accounts receivable of $150 from customers from
February.
March 20
Paid for February purchases—paying off the accounts payable
balance—of $800.
March 24
Purchased 250 shirts @$4 each for cash, $1,000.
March 27
Sold 200 shirts for $10 each, all on account, for total sales of
$2,000.
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Asset
Liability
Equity
Date
Accounts
Accounts
Accounts
Account Dr (+A – L -E) Cr (-A +L +E)
March 01
Purchased computer for $4,000 with $1,000 down and a 3-month12% note for
$3,000. The computer is expected to last for 3 years and have a residual value of
$400.
3/1
March 10
Paid the rest of last month’s advertising bill, $50.
March 15
Collected accounts receivable of $150 from customers from February.
March 20
Paid for February purchases—paying off the accounts payable balance—of $800.
March 24
Purchased 250 shirts @$4 each for cash, $1,000.
March 27
Sold 200 shirts for $10 each, all on account, for total sales of $2,000.
March 31
Interest Expense
March 31
Insurance expense
March 31
Depreciation expense.
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